You have just graduated from the MBA program of a large university, and one of your favorite courses was Todays Entrepreneurs. In fact, you enjoyed it so much you have decided you want to be your own boss. While you were in the masters program, your grandfather died and left you $1 million to do with as you please. You are not an inventor, and you do not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established franchise in the fast-foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is 3 years. After 3 years you will go on to something else. You have narrowed your selection down to two choices:

(1) Franchise L, Lisas Soups, Salads & Stuff

(2) Franchise S, Sams Fabulous Fried Chicken.

The net cash flows that follow include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the 3-year period. Franchise Ls cash flows will start off slowly but will increase rather quickly as people become more health-conscious, while Franchise Ss cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health-conscious and avoid fried foods. Franchise L serves breakfast and lunch, whereas Franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: You could attract both the lunch and dinner crowds and the health-conscious and not-so-health-conscious crowds without the franchises directly competing against one another.

Here are the net cash flows (in thousands of dollars):

d. (1) Define the term internal rate of return (IRR). What is each franchises IRR?

d. (2) How is the IRR on a project related to the YTM on a bond? For example, suppose the initial cost of a project is $100 and it has cash flows of $40 each year at Years 1, 2, and 3. What is its IRR? Use the Excel RATE function as though the project were a bond.

d. (3) What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?

d. (4) Would the franchises IRRs change if the cost of capital changed?

k. In an unrelated analysis, you have the opportunity to choose between the follow-ing two mutually exclusive projects, Project T (which lasts for 2 years) and Project F (which lasts for 4 years)

Year 0 Expected Net Cash Flows Franchise L Franchise S -$100 -$100 10 70 60 50 80 20 1 2 3 Year 0 1 2 3 4 Expected Net Cash Flows Project T Project F -$100,000 -$100,000 60,000 33,500 60,000 33,500 33,500 33,500